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Will Hedge Funds Take Over Fannie Mae and Freddie Mac?

On the back of yesterday's losses, stocks opened lower today, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average(DJINDICES:^DJI) down 0.28% and 0.46%, respectively, at 10:20 a.m. EST.

A group of hedge funds and private-equity firms are eyeing the takeover of large parts of the Federal National Mortgage Agency(OTC:FNMA) and the Federal Home Loan Mortgage Corporation(OTC:FMCC), known as Fannie Mae and Freddie Mac -- the mortgage agencies that guarantee a majority of U.S. home mortgages.

The investor group represents more than half of the ownership, by value, of Fannie Mae and Freddie Mac's $34.6 billion in preferred shares, which have been made worthless under the terms of the government's conservatorship.

Under the proposal, those preferred shares would convert to common equity in order to capitalize an insurer that would insure newly issued mortgage-backed securities. Fannie and Freddie's existing portfolio would remain under the government's supervision and go into runoff, while a securitization platform to standardize mortgage bonds would also stay under public supervision.

The proposal has the merit of speeding up the process of getting private capital to replace Fannie and Freddie in the U.S. housing system -- which is what politicians profess to want to achieve. Both houses of Congress are working on proposals to wind down the agencies; however, I feel that lawmakers lack the sense of purpose and urgency of the investor group that owns the preferred shares. However, politicians would be extremely wary of the public perception that they are handing this very profitable activity to hedge funds and private equity. As such, I'd be surprised if this proposal gained much traction in Washington.

Last Friday, I highlighted the fact that the mortgage agencies were now close to having paid -- in dividends to the government -- an amount equal to that which taxpayers advanced to Fannie and Freddie at the height of the crisis to keep them from failing (an astonishing $187.5 billion).

The news came with the companies' quarterly results, which contained bumper profits. (Since last year, the government has expropriated all profits beyond what is necessary to maintain a minimum capital position.) The agencies' profitability may attract individual (and professional) investors' attention, but I stand by the warning that I offered last week:

Fannie and Freddie may look like blue-chip stocks, but they are, in fact, special situations that require much knowledge, experience, and intensive monitoring to invest in. ... While the agencies are now safer than they were five years ago, common equity holders' position remains fraught with uncertainty.